Consumer prices are now barely rising in the euro area. Could the current low positive rate of inflation give way to a period of deflation, and if so, why would that matter?
Euro area inflation has been falling steadily for three years (chart 1), confounding the expectations of financial markets and economic forecasters. In September 2014, the euro area inflation rate was just 0.3% year on year, and inflation rates were negative in six euro area countries, three of which recorded falling consumer prices for the third month in a row. Persistent economic slack and the recent decline in energy prices were largely to blame, though structural reforms to boost competition and regain competitiveness in peripheral countries also contributed.
Clearly, the risk that consumer price inflation will slip into negative territory has risen, and the consequences of such an outcome could be serious.
The worry is that deflation would aggravate the weakness of demand in the euro area, in several ways.
First, falling prices mean that real interest rates (nominal rates adjusted for price increases) can get stuck at excessively high levels as monetary policy is constrained by the zero lower bound.
Deflation also raises the real value of a given nominal stock of debt, so the burden of debt for public and private borrowers increases, while wealth is shifted to creditors. As creditors often save much of their extra real income while borrowers typically have higher propensities to spend, the result is generally lower total spending.
Moreover, with prices expected to fall, deflation may also encourage consumers to postpone their spending.
Finally, negative inflation generally means that necessary adjustments in relative real wages between sectors or regions can only be achieved via widespread cuts in nominal wages. Such reductions tend to occur only when economic conditions are very depressed, as people become more concerned about keeping their jobs than maintaining their wage.
Deflation is not unknown in the OECD area. The most recent major example is Japan, which was mired in deflation for over one and a half decades, and where inflation has only recently moved back into positive territory (chart 2). Switzerland has also had negative annual inflation for much of the past three years. In the euro area, Greece, Ireland, Portugal and Spain all experienced periods of falling prices during the crisis, which, together with sharply lower commodity prices, helped push inflation briefly below zero in the euro area as a whole.
The current risk of euro area deflation represents a greater economic threat than the earlier transitory episode in a context of plunging commodity prices. In fact, low inflation is already having a negative impact. Given that countries in the euro area have a shared currency and cannot use the nominal exchange rate as an instrument to reduce external imbalances between the member states, necessary adjustments have to take place via differential growth in nominal wages and prices. But when nominal wage increases are very low throughout the euro area, a country can only achieve a reduction in its relative wage level via falling nominal wages. And, as already noted, nominal wage reductions tend only to be possible in very depressed economic conditions. It is no coincidence that the largest drops in wages to date have occurred in economies like Greece and Spain where unemployment has risen to extremely high levels.
Very low inflation also makes fiscal consolidation more politically difficult. Some countries are freezing nominal expenditure as a way of achieving real spending cuts via inflation, but such moves yield only limited budgetary gains in a low inflation environment.
Despite the risks, the OECD does not expect the euro area to fall into deflation. The European Central Bank (ECB) is committed to use unconventional instruments within its mandate to avoid a prolonged period of low inflation, and the measures it has announced since June should help. The ongoing shift in monetary policy in the United States, combined with a move towards greater easing in the euro area, has already resulted in a depreciation of the euro against the dollar, and such depreciation puts upward pressure on the price level in Europe. In addition, the drag on demand from fiscal consolidation is now easing. As demand strengthens, inflation should turn back up towards the ECB’s target range, although it is likely to remain well below that target for some time yet.
But if deflation is not the OECD’s central scenario, complacency would be misplaced. True, long-term inflation expectations have appeared well-anchored around the ECB’s definition of price stability. However, the experience of Japan in the 1990s, when similar measures of long-term inflation expectations consistently failed to predict deflation 5-10 years ahead, is sobering. As actual inflation fell, long-term expectations did adjust downward, but even once deflation had taken hold in Japan, expectations about future inflation were still (wrongly) positive. The longer that actual inflation remains far below 2%, the more likely it is that long-term expectations will become de-anchored from the ECB’s objective, making it even more difficult to return to the target range.
This article was prepared by the OECD Economics Department for the OECD Observer, October 2014. Stephanie.Guichard@OECD.org can be contacted for further commentary.
©OECD Observer No 300, Q3 2014